Market Design & Regulation

Featured Piece

nouriel roubiniWhat To Do If a Large, Complex Financial Institution Fails,” by Professors Nouriel Roubini, Viral Acharya, Matthew Richardson, Daiwa Institute of Research, 2010.

ABSTRACT

We consider four different approaches to the resolution of distress or failure of large, complex financial institutions (LCFI): (1) laissez-faire or market-based; (2) regulatory forbearance; (3) receivership in hands of government or government-appointed regulator; and, (4) distressed exchanges. We investigate several criteria for evaluating these approaches, including which method works best in liquidity versus fundamental crises, the difficulty with managing failed institutions and the resulting systemic risk, the issue of moral hazard and its impact on future crises, and the impact on taxpayers. While a market-based approach helps resolve insolvent institutions and provides discipline, it may not work well in dealing with systemic risk during a crisis. Regulatory forbearance achieves almost the opposite outcome, simply blunting systemic spillovers during a crisis but at the cost of severe moral hazard. On balance, we find most attractive the receivership approach with temporary transfer of ownership to a resolution authority that provides an orderly restructuring and liquidation (if needed) of the distressed LCFI’s. While distressed exchanges also offer a market-based solution that would prevent moral hazard, there remain question marks around their swift implementation for LCFI’s and especially their vulnerability to sparking contagious runs on other LCFI’s.